Johnson Controls International plc (JCI) Earnings Call Transcript & Summary

All right. Good morning to everybody joining us in the room and welcome to everyone on the webcast. We're really excited to have Johnson Controls with us. On stage with me is George Oliver, Chairman and CEO. And we thought we would just kind of go jump right into the fireside chat.

But maybe just as an opening question, just can you provide any kind of state of the union that you're seeing out there given we're sitting in December?

Yes. So when we look at the guidance we gave for 2023, you look at a lot of the macro indicators and take into account not only the Dodge, but the ABI as we look at our solutions business, and when you look at the Dodge, that was very strong in the fourth quarter, and that continues as we're executing on projects and the turn of our projects. When you look at ABI on the front end, we see that to be very strong. And even though it's come down, it's still a positive. Then when we look at the overall demand in the commercial space, given the secular trends that are underway, which is big focus on getting to net zero with sustainability, big focus on indoor environmental quality, especially with air quality. And so for us, a lot of those secular trends are playing through. And so as we -- we've set up the businesses not only as the -- when we look at our project-based business is making sure that we're focusing on those outcomes that we can deliver around decarbonization, around healthy buildings. So retrofit market as a result is very strong. And so that's continuing. And as you all know that we're -- with our digitalization of what we're doing within our services is not only taking everything we do today from a service standpoint, but to now capitalize on these bigger outcomes with the use of the data and the work that we're doing around AI and ultimately changing the outcomes as it relates to energy being consumed and into air quality. And so I think those are the big trends that we see from a -- when you look at our structure and global products, we're -- we've been reinvesting in our product portfolio nicely over the last 4 or 5 years. I think we're positioned very well now to capitalize on these trends. We've been investing in OpenBlue, and that continues. So those are the things that we look at. I mean some of the watch areas, I think as we look at the shutdowns in China and what is that going to mean and how is that going to continue, although we've had -- we had a very strong quarter there in the fourth quarter and seeing that somewhat continuing here. And so that's a watch item. Certainly, in the residential space with the significant demand that we've had in the last couple of years and how that's going to play out now in '23. So those are the areas we watch. But overall, we see, especially in the commercial space, very strong demand for what we do. And a lot of it is because of how we've repositioned Johnson Controls and being able to not only lead through our product technology, but that combined with OpenBlue and the digital technology is really what's differentiating what we can do now to capitalize on these secular trends.

Great. And then can you just remind us when you think about that building -- your buildings business, how much is driven by kind of new versus kind of retrofit or renovation?

Yes, through the cycle, it's typically 50-50. But even with this cycle, this cycle has been a little bit different because of the significant demand both in the recovery as well as the retrofit. And so we have -- it's been very strong on both sides through -- and that's what's really elevated the overall demand. And so I think as we look at, like, for instance, decarbonization, I share this because you cannot achieve your net-zero goals without decarbonizing buildings. Buildings represent 40% of the global carbon footprint. And so when we go in, our sustainable infrastructure business, when we look at that, it's not only -- think about sustainability as electrification. We do electrification with heat pumps -- with our lineup of heat pumps. It's then digitalization. So not only the heat pump, but then how does that then get digitalized or connected with all of the other building systems. It's the use of the data, and you apply AI, and then you change the outcomes. And we -- when we do that, we can reduce energy 30%, 40%, 50%. So that's the reduction of the demand. And then the remaining supply is what is the most optimal renewable supply of energy, and that ultimately gets to a net-zero building. And so I think on the retrofit side, when you look at the current buildings globally, 70% of that building stock is going to be in operation by 2050. And so when you look at the commitments that governments have made as well as companies globally have made to get to net zero, you have to ultimately address the building. And so that's where I think we're going to be positioned well in spite of any economic slowdown in how we're going to capitalize on that. And so that's one of the things, I think, is going to be exciting for us.

Great. And you talked about digitization, right? And so can you talk a little bit about -- and maybe in a net-zero building as the example -- kind of a traditional building's management solutions that's doing the HVAC and the lighting? And then some of these other things you're talking about with OpenBlue, how do they talk to each other? How do they fit together?

So I think it's important to understand our algorithm here because our service business -- historically, we've got a $6 billion service business, and for the most part was break/fix -- mechanical break/fix. And it's a great business, high margin, creates a lot of value for what we do, mainly labor-driven, not a lot of data or software being driven. And so it's -- our strategy has been to not only go back and look at our -- to get everything connected. So everything new going into the installed base is connected. So connectivity is #1. And then with that, you then immediately can manage that device or a piece of equipment through warranty. And then with that period of time, you have an incredible opportunity with the use of the data to add more value because of the differentiation and the outcome that you can produce with that data. And so it's getting everything connected. It's going back after to the installed base set, for whatever reason, over the last couple of decades, when you look at our installed base, we were only serving, when we started this journey, about 35% with some level of contract. Now we're getting -- we've -- over the last few years, we're up to about 45%, and we believe that there's an incredible opportunity to go back into the base and being able to not only create a different value proposition by getting it connected, collecting the data and ultimately changing the outcome. So it's the connectivity, getting a higher level of PSAs. And then once you do that, then -- with OpenBlue, when we think about digitalization, it's the connectivity. It's being able to then, with that connectivity, apply -- utilize all of the data, be able to apply AI to the data and fundamentally change the outcomes. And that -- once you get that connectivity, you have layers of value that you can create with the data. And so that on a go-forward basis, then you get more revenue per customer. So you go to the PSA, to more revenue per customer. And then with the connection, with that, we're beginning to see in the connected environment, we're improving, like, for instance, on chillers, we're reducing downtime by 2/3 with that connectivity. That's one level of value. In energy -- with energy consumed, we can reduce energy, like I said, up to 40%, 50%, utilizing all of the data within the building. So it's the connectivity. It's getting it into contract, adding more value with the use of the data. And then what we're finding is that from a service standpoint, we elevate our ability to be able to provide service, and a lot of that is being done through our remote operation center. And then because of the customer experience, you reduce attrition. And so when you look at just our service business, why we've gone from kind of low single digits to now high single-digit service growth, it's really an output of the digital connection. Then when you layer on the secular trends that we're going after, like, for instance, indoor environmental quality, the data suggests that the largest cost our customers have is their people. And then when you look at the environment they're in, we've shown data that when you elevate the indoor environmental quality, you can get significant productivity. It isn't just for the health and safety of the building, but it's also for the productivity that occurs within the building. And so our indoor environmental quality offerings now, we have about 25 different solutions. We go in and do the same. It isn't just the piece of equipment or increasing the filtration or adding a device. It's how that equipment is operating in the environment and what is the occupancy and what is the -- what are the trends over time and how do you make the system -- the building system dynamic to be able to accommodate and ultimately create an output. So when you talk about digitalizing a building, it's taking what we're doing with building controls, with all of the other censoring within the building, now being able to layer on and bridge, we have OpenBlue Bridge where we can not only connect to all of our systems, but all of the other building systems, and then being able to fundamentally change the outcome of the building. And that's -- and take building controls is a good example where we have a leadership position with our Metasys platform in complex buildings. We are ultimately now making Metasys intelligent and dynamic, opposed to you go in and configure Metasys and then it runs the building. And then it's manually adjusted over time. Now how do you automate that and make it dynamic with the intelligence that you're gaining from across the building? And ultimately, how you're delivering a different outcome? So that is the fundamentals of taking a building, being able to not only digitalize at the edge with the equipment, but then how all of that equipment comes together into one platform and then ultimately creates a what I would call an autonomous building, which isn't too far into the future.

Interesting. And then can you remind us, is this something that you're just doing on your own? Are there partners? How are you building this out?

Yes. So when we build an ecosystem, so we believe that we bring incredible domain. So a big value proposition for us is not just the leadership equipment. But now with the leadership digital platform within leadership solutions. And so we are -- we believe, an advantage is the 3 and having the footprint that we have globally with the direct channel to our customers is going to be an important element to create these recurring services. And so we focus on our domain, what we do and within the building. Obviously, we've been developing a lot of our digital capabilities, but we've also been acquiring as well as partnering with technology companies that complement what we do within the ecosystem that we're creating. And so we work with a number of partners that's driving a lot of innovation and really differentiating the solutions that we can develop and deploy working together.

Great. A big topic in the HVAC world, you touched on electrification. Can you talk to us about your heat pump offering, both maybe from a commercial aspect and then also from a residential? .

Yes. So when you look at heat pumps, heat pumps represent well over $3 billion of our offering today. And certainly, there's a big value proposition especially around the electrification. I think if you look at the overall market, it's about $100 billion, and it's going to grow, we estimate somewhere mid-single digits. Obviously, high growth in North America and [indiscernible] because you start from a much smaller position. Asia Pac is roughly 2/3 of the market, and that has been historical where -- with the climate there and the ability to use the [ duc-lit ] systems that with the split systems being able to not only heat as well as cool, but with the environment you're in, very successful in being able to develop that market for the last number of decades. And so as I think about the technology now, we're spending 90% of our R&D in products and capabilities that really are driving sustainability. And heat pumps is a key element of that, the electrification side. And the value proposition is not only the electrification, but then the efficiency that you gain with some of the new heat pumps and the new technology, you get a 3:1 efficiency. And so it starts with electrification and then combining it with the other digital aspects of the building, which creates the outcomes that we can deliver within Johnson Controls.

Great. And then maybe can you just remind us the impact these initiatives are having on kind of your pricing model, and then we can maybe get into the cost side as well.

Yes. So let's -- I'll give you the framework on pricing because I think it's been a little bit of a journey here. So we've been developing pricing corridor or fundamentals here over the last number of years. And we have 2 models. We have the global products model, which is more transactional. We have $10 billion of product that goes through our external channels. And then we have roughly $16 billion that goes through our direct channel, which are solutions, which then ultimately lead to recurring service. And those tend to be a longer lead. And so when we get into this higher inflationary environment, like if you look at 2022, the projects that converted in '22, many of those projects were booked prior to the recognition that we were in a sustained period of inflation. And therefore, we had underestimated what that level of cost was going to be through the completion of that project. So that's what early last year when we get into some of the margin challenge in our solutions-based business was that. And so on a forward-looking basis, we've got a much more robust model in how we're projecting inflation and cost. And then when you -- when you're building a solutions-based business, you're focusing on delivering value. So it isn't necessarily a cost, but you want to understand what your cost is going to be and what the inflation is going to be, then you price for value on top of that cost. We've done that very effectively, and you saw the latter part of the year. And then as we set up for this year, we have strong margin improvement in our field-based business because of that, because of the way that we've priced and we've accounted for future inflationary costs at a much higher level. And then in the product-based businesses, we've demonstrated that more transactionally, it was shorter cycle to be able to get the value proposition and ultimately price ahead of inflation on that. And so when we ended the year in 2022, we ended up about $50 million positive price/cost. And then as you project what we've now got in backlog and how we're going to execute in '23, we are positioned well ahead or continuing now to stay ahead of the inflation environment. And so that -- and then the value is really through the differentiation now that we're providing. It isn't this idea that we're a contractor, and we're going to do 3 bids and a buy. It's we're creating a whole different outcome than what historically we've done as a field-based business that then translates into a recurring revenue, into service, which is very important, because that's where the value is extracted not only for the customer, but also in return for our shareholders.

Great. And then maybe just dovetailing on that, just any kind of view on the supply chain?

So supply chain, as we navigated through the inflationary period, we also had major challenges last year -- early last year with supply chain like most other industrial companies. And it happened to be during our lower seasonality typically, our lower volumes in the first half of the year. And so when we did the reset was -- it was clear that we were ramping up for our seasonality. And our typical ramp-up on average is about 10%. And so we were -- as we were working through the supply chain challenges, and it was mainly driven by microchips and semiconductors, and we worked through that and have worked strategically with all of our key suppliers to make sure we're getting our fair share of the supply more than our fair share, we -- obviously, because lead times were almost doubled as far as those components, that created -- that really created the issue. Now doing that, we were able to ramp up in third quarter. We were able to have a nice -- at a similar elevated level in the fourth quarter. And I'd say that as we set up for '23, again, we're continuing to see improvement. That being said, there's still some disruption that's being felt. But we demonstrated that we kind of get over the hump. We've been continuing to make sure we're getting more proactive looking at the future demands, especially where we have product segments that I would say have unconstrained market demand and how do we continue to ramp up supply chains and ramp up our own capacity to be able to now capitalize on what we see to be some very attractive segments in the market that I think we're uniquely positioned to be able to capitalize on. So I think it's going to take us -- when you look at the 2 elements of product recovery. We have product backlog recovery. That's continuing. Then we have our field-based business backlog, which when you look at the total backlog of the company, we're about $13 billion. Those projects, we -- they got extended 1, 2, 3 months. And so when you're extending projects like that, you're incurring extra cost. Now we showed in the fourth quarter, we started to improve, and that's going to continue. So we get our project cycle time back to where it was prior to the pandemic. And so that not only helps efficiency, but helps us to be more agile as we're positioned to capitalize on the growth that's coming into the market. So I feel good about the work we've done. There's still work to be done. But through the course of the year, I think we'll get back to where we were prior to the pandemic.

Great. And then I have another question here, but if anyone does have a question, feel free to raise your hand and we can get a microphone to you. But George, maybe you can remind us where you are on the -- both the previously announced kind of COGS and SG&A [ Cost-out ] programs.

Yes. So we announced -- this goes back a couple of years. We announced $550 million of savings, both through COGS and SG&A, and that was over multiyears. And then we accelerated that last year as we get into this, obviously, the challenge we had with the price/cost, looking at how do we accelerate these other programs to offset the short-term impact of that while we were recovering our margins from a pricing standpoint. And so as a result of that, we've been able to accelerate the $550 million to now a level of about $665 million. And so a lot of that is because not only we executed better on what we had originally planned, but we're also now going after additional opportunities that we saw as we continue the transformation of the company. So I think the way that it was split was we delivered about $60 million in the first year, last year, maybe about $260 million. And then the most of the remaining benefit will come through in 2023. And that doesn't end. I mean we -- when you look at our company, there's still significant opportunity as we've been working to take all of what we do, simplify it, functionalize it, simplify it and then automate it. We're midway through that journey. And so we're continuing to work on, obviously, simplification, reducing cost functionally and then working to deploy our ERP strategy, which is a multiyear strategy. And as that gets implemented, that will get another layer of savings on an ongoing basis. So all the work we're doing, what we've said in the model is that on a -- in a growth mode, we get about 30 basis points of mix and leverage on our volume. This allows us to get more with the work that we've been doing on the COGS and SG&A, which really presents to be able to get to incrementals of better than 30% on a sustained basis. And those are the key elements of the overall model that we put together that we communicated back during our Investor Day.

Great. You mentioned a couple of times this kind of the thought of global stimulus. Obviously, the Jobs and Infrastructure Act, IRA, at least here in the U.S., kind of what are the ones that you guys are watching most closely?

Yes. So let's start with -- in the U.S. and the IRA. That is the largest bill -- climate change bill ever passed. And certainly, a lot of focus within that is with what we do. And we actively participate and help define that because we had a -- we've been in the process of educating a lot of our constituents on what is required to ultimately get to net zero within buildings. And so as I said earlier, decarbonization in buildings is electrification, digitalization, and then the remaining demand for energy is renewable supplied. And we have a sustainable infrastructure business that last year, we delivered over about -- I think it was 50% growth in orders, but we have a pipeline of about $1 billion business today, but we have a pipeline of over $7 billion. And so all of these acts -- the IRA has got incentives for heat pumps. It's got incentives for solar, renewable supply. And when we look at this bill, that's just the stimulus element of it. That translates into, for us, let's say, 5 to 10x the revenue opportunity with the value proposition that we bring within the U.S. When you look at, what is it, the REpowerEU, that's after, obviously, the EU Green Deal, which is committed to get to net zero by 2050. It also is built off of this energy efficiency directive. It's off where they've actually put in building performance or energy performance standards for buildings. And when you look at that bill, that's to reduce the fossil fuel supply energy from Russia by 2027. So within the bill, you have to -- all-new construction of buildings have to be net zero by 2027. I mean that's not in the too distant future. So that's a big element of it. It requires the bottom 15% of buildings to be retrofitted or upgraded and retrofitted. And then there's, with the performance standard, going to be certificates of compliance. So that, again, is going to play to our strengths relative to, again, electrification, heat pumps, digitalization with OpenBlue and then our ability to be able to combine that with renewable supply that gets to much different outcomes within the building. And so those are very much aligned to -- we've been very active in the development of those bills because we believed it was important to educate all of our constituents. I've done that not only with my participation in the BRT, leading the Energy and Environment Committee, but also with the sustainable markets globally with a buildings task force to get everyone educated on -- with the commitments that are being made, how do you actually execute on those commitments with what we know today that we already have technology that we can use to solve the problem. So I think very much aligned to what we've been doing.

Great. A vertical that's been getting a lot of attention, data centers. Can you just kind of talk about some of the trends you're seeing there?

Yes. So data centers has been an incredible market. It's about 50 -- I'd say about $50 billion today. We've been positioning our -- not only our traditional offerings with our chillers and the like, but also now the expanded capabilities we have with Silent-Aire to capitalize on that opportunity. It's very consolidated to roughly 5 data center providers. We have very strong relationships with all of those data center providers. And so a lot of this, again, is not only the leadership equipment and capability, but then how it's configured, utilizing not only the equipment but with the digital offering that ultimately creates the performance that they're looking to achieve because you can imagine this is an area that it's created just because of what they do, there's a significant carbon footprint. And so how do you always work to -- continuing to optimize that environment doing it at the lowest -- not only the lowest cost, but the lowest energy consumed to be able to minimize the global impact from a carbon standpoint? So for us, it's a market that we believe is going to, at least for the next 5 years, going to have significant growth. And for us, the way that we position our applied offering, combine that with Silent-Aire, with our go-to-market, with our digital solutions, it's going to be a very attractive market for us. And we -- you've been seeing that in the orders that we've been getting, and it's been -- a lot of it's been driven in North America, but it is global that we've been really driving our new products that we've been developing for this segment, and we're getting some nice orders that we're seeing within our applied business.

Great. And then maybe can you talk a little bit about how the combination -- like so bringing in some Fire & Security into the conversation, how that kind of helps enable this?

Yes. So Fire & Security, when you look at a smart building or digital buildings, Fire & Security are critical elements because they are -- they do have a lot of sensing into the building. A lot of that data that comes from those sensors are critical to being able to create the outputs that we're working on creating. And so longer term, they're very -- and the reason why we did the merger with Johnson Controls and Tyco was because of that, that these are critical building systems that we felt. They come together under one roof. We create one platform. Then you can ultimately create much different outcomes. And so I think that's playing out as planned. I mean each one of those businesses today, we still serve the individual markets. And with the development of new products, we're capitalizing on market share at that individual level. But more important, it's how we're taking the digital content of those buildings, and we're combining that with our OpenBlue data capabilities that fundamentally is not only going to enhance the offering we have into each one of those domains, but more important in how it all gets configured into one solution within the building. And so we're on track, and we're seeing -- although I think historically, Fire & Security has been lower growth than HVAC. And so Commercial HVAC right now is above market growth. I think we're going to benefit from the digital aspect and get additional growth supporting the overall digitalization of these offerings that we're bringing into the market.

Great. And then just thinking -- building on that HVAC comment, can you talk about some of the trends, and maybe by verticals, what you're seeing institutional, commercial, resi, just kind of industry trends.

Yes. So the institutional space for us is a very attractive space. It's a large portion of our portfolio, 25%, 30%. Health care has been strong. Education has been strong in that space. When you look at resi, the resi business, as I said earlier, we've gone through a huge demand curve over the last couple of years post pandemic. And I think that's going to come down and normalize and projection that's going to flatten out. We're going to see the benefit of the of the 2023 compliant -- DOE-compliant units coming into the market with a higher value proposition. So overall, I think -- and then from a service standpoint, for us, retrofit and service is where we see across these segments, the ability to really change the game, right, with what we can do to ultimately focus on the biggest problems our customers are trying to solve and do it differently than what historically has been done. And so on the service side is where I'm pretty bullish that we can convert to a much higher value propositions. We can sustain much higher growth. And then through these outcomes we deliver, it creates more recurring revenue on a forward-looking basis. So that gives -- I mean it's hard to -- given the environment we're in, with the inflationary environment we're in, the supply chain disruption, the Ukraine-Russian conflict, you've got the China disruption, it's hard to predict with all of that where this all goes. But I think the underlying trends in the space we're in, in the commercial space, and we're starting the year with a very nice backlog. So we've got $13 billion of backlog. And then the underlying trends with what we see -- will it be pockets of softness? I'm sure. But the net of it that we have just, I think, an incredible opportunity with the problems that we're solving with how we're solving them that it's going to create that demand profile that I believe is going to -- some of which will be anti-recessional when we go forward. And so when I look across the segments, you could argue, historically, some of those segments seeing some pressure, yes. But now with the trends that are underway, these problems being elevated to a higher level of priority. And then as a partner, when we go to market now with these -- what I would call with these outcomes, we're operating at a very different level within the customer. Buildings -- historically, when you look at the multiple systems that are separate and apart, they go to market kind of in their lane. When you go to market with an output of reducing energy by 50%, that's a whole different customer that you're dealing with. And so what we're focused on now is this last mile of transformation, and a lot of that is helping the customer transform so that they can achieve the commitments that they've made or the problems they're trying to solve effectively as a partner.

Would the customer be having this conversation with you even irrespective of stimulus? Is this something that self-funds for them? Or what's that kind of conversation lift?

Yes. That's a great question. Because when you look at our value proposition, buildings, because of the way that they've been configured, because of the way they've been operated, system separate and apart, they haven't been really in the core strategic focus of our customers. The pandemic immediately elevated that with mainly health and safety, right? And then the recognition that there was a lot of room for improvement as it relates to indoor environmental quality and the impact that, that has on their people, but at the same time was the acceleration of the commitments globally to get to net zero, but the appreciation that buildings represent a big chunk of that. And so I think as we have elevated our discussions and the ability to fundamentally change how these problems are solved, we're getting incredible traction with the pipeline that we're developing in our sustainable infrastructure business, with the pipeline that we're developing within our OpenBlue, kind of converting services to being digital services, deploying data level solutions. So a lot of the trends that I see underway are going to play out and I think are going to play to our strengths.

And maybe just in the last remaining time here. When you talk about that conversation, did you have to bring different people into the organization or retrain those people to be able to have this conversation?

Well, from a digital standpoint, we've gone through a digital transformation, not only inside Johnson Controls, but then from an outside in, in creating now a digital industrial company. And so as a result of that, the answer is yes. I mean we brought in Vijay Sankaran. We've got a world-class digital team. We put all of our software assets together, not only in all of our traditional platforms, but now how they converge and ultimately get deployed with OpenBlue is very different. From a go-to-market standpoint, developing commercial acumen with digital -- digital commercial acumen, going from a company that sold equipment or sold brake fix maintain to now selling a digital solution that is creating an outcome and ultimately get through software with the utilization of data. And then from an overall -- when I think about the enterprise, taking what we've done separate and apart within an enterprise, we're operating as one enterprise, leveraging life cycle product development, so that not only we have a leadership product, but that product is designed and developed to be able to be serviceable through the life cycle with the connectivity, so product level, then the OpenBlue Digital platform. And then what we've learned is that our footprint globally, the technician that we have on the front line and enabling them with these capabilities takes -- they today are a big reason why the customers do business with us today. It elevates their game in an incredible way because we've given them more tools in their toolkit to be able to create value to really differentiate from the competition. And we're seeing that firsthand now because as we're now changing those skill sets and elevating those skill sets that we're starting to see where we have connectivity and where we've done it successfully. We're seeing now those additive services, that additive growth above and beyond what historically we've performed.

Great. Well, I think we'll leave it there. I'd like to thank Johnson Controls for being here and everybody else and hope everyone's well. Thank you.

Perfect. Thanks, John. And great being with all of you today. Thanks.